Tuesday, April 13, 2010

Own the Fed — the Program, Part I: The Crisis

Predicting the future is always a risky business. Cassandras are rarely popular, especially when they are right. On the other hand, being wrong to any significant (or even insignificant) degree is provocative of ridicule. Given that, however, we'll take a chance and make a prediction. If things continue to go as they have gone since the beginning of the "Great Recession" in August of 2007, and policymakers continue to apply discredited Keynesian policies based on outdated and disproved principles of the British Currency School, the United States — the world — will experience a financial meltdown that will make the Crash of 1929, the Great Depression, and the so-called current Great Recession pale to insignificance.

We anticipate that many people will reject this prediction. Economic analysts, Federal Reserve authorities, and politicians without number have been telling the world that the crisis is over, and have to some extent staked their careers on being right. According to conventional wisdom, the long, slow recovery has been in progress since July 2009. (Daniel Gross, "The Recession is . . . Over?" Newsweek, July 14, 2009.) In any event, the general belief is that principles of Keynesian economics, correctly applied, will prevent a recurrence of the economic catastrophe that brought the world economy to its knees from 2007 to 2010.

Such baseless optimism is not new. Similar statements regarding recovery in the United States were made in the early 1930s before the application of Keynesian principles. Matters did, in fact, improve slowly in some sectors between 1930 and 1933, but then catastrophe struck again. As Dr. Harold Moulton related,
The situation was relieved somewhat by the moderate recovery which occurred both in business activity and security prices in the second half of 1932. But in the winter of 1933 the business situation again became worse, and the collapse of the banking structure ensued. (Harold G. Moulton, The Recovery Problem in the United States. Washington, DC: The Brookings Institution, 1936, 53-54.)
Contributing to the problem is the vague impression on the part of many people — academics and policymakers especially — that the progress of depression (or recession, if the word makes you feel better) and recovery is somehow "uniform" in some fashion. That is, our understanding of history, grossly oversimplified, is that a rapid downturn occurs. After this, the government implements programs that foster economic recovery at a more or less steady and regular pace. Government programs are necessarily effective and will always bring the anticipated result. Any improvement in any sector of the economy is taken as a "sign" that the recovery has begun, and may even be well under way.

Having committed themselves to the position that recovery is in progress, politicians cannot easily change course. In 1932 Herbert Hoover declared, "Prosperity is just around the corner." The moderate gains experienced in some sectors during his administration appeared to bear this out. Unfortunately for Hoover, however, the sector that most influenced the ordinary voter — employment in wage system jobs — continued to suffer. Neither was the overall productive sector experiencing anything but the most ephemeral gains. This ensured the election of Franklin Delano Roosevelt later that same year. As Moulton pointed out,
Production and employment are basic and ultimate points of reference in modern industrial life. Depression, like prosperity, is a phenomenon which is significant primarily in these terms, and no understanding of the factors of recovery may be gained without a thorough consideration of these two elements of economic activity. (Ibid., 114.)
Hoover learned the importance of employment and sustainable production too late and to his cost. This is a lesson that the present generation of policymakers with their obsession with Wall Street and maintaining the inflated price level of secondary debt and equity issues would do well to heed. Unfortunately, the signs are that the current "unofficial" 17.5% unemployment rate as of March 2010 is not being given the importance it deserves.

At the same time, the productive sector is also receiving short shrift. This is misguided from any orientation, whether you believe that 1) production should be fostered because "jobs" are an economic output of production, 2) increased production will create jobs that, combined with higher wages or lower prices, will redistribute the necessary purchasing power, or 3) direct ownership of the means of production should supplement and, eventually, replace wage system jobs as the predominant means by which people gain income, with the increased demand resulting from consuming rather than reinvesting capital income supporting sustainable production and creating jobs naturally.

Part of the problem is that, just as there is no single cause of a depression, neither is there a single cure, or a single sector of the economy on which efforts should be focused — regardless of its political power, wealth, or influence. Evidence suggests that the Great Depression was not a monolithic single catastrophe. Instead, it appears to have been a series of profoundly disruptive economic earthquakes, each one hitting the world before the global economy had recovered from the previous disaster, and each one feeding on — or being fed by — the previous disaster.

There was, of course, the Crash of 1929. This appears to have been largely the result of massive creation of money for pure speculation. (This was obscured to a significant degree by the fact that money creation for productive purposes proceeded apace, serving to mask the huge amount of non-productive money creation.) When the inevitable adjustment came, the market value of business assets fell far below not just the grossly inflated speculative price that had been bid up, but in reaction fell below the real value as well. Collateral for business credit either disappeared entirely, or was of such uncertain or reduced value that lending institutions were unable to extend credit. The Crash itself was not a cause of the decline in production, but a symptom of the inflation of the value of collateral assets, both sound and, especially, speculative.

The reduction in the value or even existence of collateral for business credit was followed by reductions in employment as businesses either went bankrupt or cut back on production. Again, this was not a direct result of the stock market decline. It was due in large measure to two factors: 1) the failure of the banking system to discover an alternative to traditional collateral, and 2) the fixed idea that production (and thus productive credit for business) is a derivative of the supply of existing savings accumulated in the system, and, consequently the equally fixed belief that no new investment can take place unless consumption is first curtailed.

Because savings equals investment, acceptance of the tenets of the Currency School necessarily meant that a decline in the value of investments was presumed to dry up the supply of money for new capital investment. Those in charge of setting economic and monetary policy in the 1930s were as unable as the powers-that-be of today to grasp the fact that financing for capital formation is not — and never has been — dependent on the amount of quality of existing accumulations of savings.

Adding to the decay or virtual disappearance of collateral was the fact that the burden of debt assumed by government, businesses, and private individuals quickly assumed crisis proportions. While popularly blamed on the decline in share values and the subsequent drying up of credit, the facts of the matter were otherwise. As Moulton pointed out, even had the stock market not crashed, and even had the commercial banks not stopped extending credit for productive purposes, many businesses and individuals would have been unable to meet existing debt service payments. Both the sheer quantity of debt as well as the disadvantageous terms on which it had been assumed ensured that serious problems were rapidly surfacing. As Moulton explained, highlighting the incipient disaster inherent in relying on consumer credit and government spending instead of production to keep the economy going,
Meanwhile the debt situation was also becoming increasingly serious elsewhere. State, city, and local government units, which had for years been borrowing for various and sundry purposes, were finding it increasingly difficult to meet interest obligations. In the field of urban mortgages, large numbers of individuals whose incomes were steadily shrinking were unable to continue meeting interest and mortgage installments. Urban real estate mortgage companies and their bond issues, which were inadequately secured even on the basis of pre-depression values, were falling into default. The railroads seemed threatened with bankruptcy, while many public utility and industrial corporations were also in serious condition. The stability of insurance companies and other financial institutions, of trust and endowment funds, was directly dependent upon the continuance of the flow of interest and mortgage payments. Involved in the whole network of relationships was the safety of the deposits and investments of all classes of people. (Ibid., 52.)
The surge of bank failures in 1933 was caused primarily by the drastic fall in value of the asset portfolios of commercial banks and the general inability to replace such toxic assets with new, sound assets backed by the present value of existing or future marketable goods and services. That is, the commercial banking system was, by and large, saddled with enormous amounts of bad assets that they had to write down, but were unable to replace with new loans made for financially feasible productive projects instead of speculative securities purchased on the secondary market. This virtually ensured that production would remain low, and unemployment high. As Moulton described the progress of events,
The final stage in the process of financial disintegration was the collapse of the American banking system. Small-town and country banking was, of course, dependent upon the prosperity of agriculture. During the first stage of the depression the mortality rate was greatly increased, and in the second stage the whole rural credit structure was undermined. . . .

Meanwhile, also, the decline in the value of securities was adding to banking difficulties; and a race for liquidity began. As margins on collateral loans became inadequate, payment was demanded and often the collateral had to be taken over by the bank and sold at a loss. The shrinkage in the value and the income of bonds directly owned by banks also presented a serious problem. Fearful of still further shrinkage in value, and often in need of cash, the banks attempted to sell their holdings of second-grade bonds. The combined result of the liquidation of the collateral of distressed borrowers and of their own investments was to demoralize still further the security markets. The greater the efforts of the banks to save themselves by the liquidation of securities, the greater became the demoralization of security values. (Ibid., 52-53.)
It should not be necessary to remind the reader that the circumstances and events related above are purely historical. Any similarities between the events contributing to the severity of the Great Depression and those of today, however, are certainly more than coincidental. They are a direct result of the insistence of the powers-that-be on applying the same tried-and-failed solutions as before. The slavish devotion of mainstream economics, whether Keynesian, Monetarist, or Austrian, to the tenets of the Currency School has all but guaranteed that no solution can be developed that takes reality into account and would therefore be effective.

In the 1930s this led to the insanity of the Federal Reserve policy that set off the near-fatal blow to the economy known as the "Crisis of 1937." In their anxiety to prevent another speculative bubble — and failing to differentiate between "good" credit for productive purposes and "bad" credit for speculation, consumption, and government spending — Federal Reserve authorities increased the discount rate. This artificially forced up the costs of doing business by making capital credit more expensive, thereby cutting off the life's blood of the economy. The Federal Reserve's bad monetary theory and practice thereby stifled the still-tenuous recovery, sending the economy into a precipitous downturn. (Harold Moulton, Financial Organization and the Economic System. New York: McGraw-Hill Book Company, Inc., 1938, 411-417.)

Moulton's conclusion is significant and bears repeating, especially in light of today's strong, nearly invincible belief that the Federal Reserve controls the economy the way the State is presumed to control the entire social order: "The inability of the Board of Governors of the Federal Reserve system to control the business situation is simply evidence that many of the forces, which account for business fluctuations, lie beyond the control of monetary policy." (Ibid., 416.) In other words, despite the adamantine faith in the power of the central bank and the State to reconstruct reality, even the strongest faith, when misplaced, crumbles when faced with empirical reality.

An understanding of the act of social justice and humanity's political nature would have gone a long way toward assisting the powers-that-were in the 1930s to develop a more rational approach to the recovery problem. That was not to be, however. Instead, what they got was Keynesian economics, a rehash of the tenets of the British Currency School that, perhaps not surprisingly, provide the basis for virtually all mainstream schools of economic thought, including the Monetarist and Austrian, to say nothing of the minor schools as well.

Still, it was not until after Franklin Delano Roosevelt was elected and inaugurated in 1933 that Keynesian principles were applied in an attempt to stimulate economic recovery. Even then, however, it seems a reasonable position to take that employing Keynesian economics may have slowed recovery dramatically. (Burton Folsom, Jr. and Anita Folsom, "Did FDR End the Depression?" The Wall Street Journal, 04/12/10, A17.) Using Keynes's recommendations as the basis for the New Deal programs may even have been a significant contributing factor to the "Crisis of 1937" when the economy once again plunged into depression before full recovery.

Ironically, Amity Shlaes makes a good case that the New Deal was, in large measure, FDR's implementation of policies and programs initiated or developed by Hoover. (The Forgotten Man: A New History of the Great Depression. New York: Harper Perennial, 2008.) For all the vituperation heaped upon Keynes's theories, Keynesian economics, far from providing a framework for recovery, may simply have been "plugged in" as the most plausible justification for what was already being done. Keynesian economics didn't have to make sense, it just had to sound as if it did.

In any event, recovery was not stimulated by artificial demand created by the State as fast as it could create debt-backed money. Instead, recovery was fueled by the very real growth in demand caused by the desperate need for material to carry on the Second World War. It might not be too much of an exaggeration to suggest that Adolph Hitler saved FDR from being labeled one of the worst presidents in American history.

There are thus significant questions in many people's minds — especially those who are out of work or whose employers are in danger of bankruptcy — as to the reality of the presumed recovery the United States economy has presumably experienced since July 2009. Added to this are the reports of the mavens of the media, who have managed to contradict themselves on a daily, sometimes hourly basis. No one seems able to say when — or if — the recession has ended.

The experts — as well as the ordinary people who have a vested interest in whether or not they can make a living — are clearly confused. No one has any clear idea as to what state the economy is in, much less what should be done about it, to say nothing about having any cogent or even comprehensible vision as to where we should be going.

To take merely one example, interpretation of the unemployment figures — considered a "leading economic indicator" — fluctuated wildly in the first quarter of 2010, at a time when the economic recovery was presumably well under way. To give a little context to the reports, the "official" unemployment figure has been holding steady at around 9.7% for some time. The real unemployment rate supplied by the Bureau of Labor Statistics of the Department of Labor, however, was 17.5% for March 2010. (http://www.bls.gov/news.release/empsit.t12.htm) The real unemployment rate is uncomfortably close to the figures from the worst years of the Great Depression — 17.4% in September of 1932. It is therefore not all that surprising that statistics would be manipulated or "adjusted" to avoid spreading panic. There has also been a studied avoidance of the word "depression," possibly for the same reason.

To consider the possibility that the powers-that-be have been redefining essential statistics in an effort to change reality is not really all that outrageous. After all, the premier defunct economist of the modern age, John Maynard Keynes, openly admitted in his 1930 A Treatise on Money that the State has the power to change reality by re-editing the dictionary. If, therefore, the State declares that the recession is over, it must be over. If the State declares that a depression is actually a recession, that must also be the case. If the State says that only 9.7% of the workforce is unemployed instead of the more realistic 17.5%, then only 9.7% of the workforce is out of work.

Of course, all of this fits in perfectly with the fact that the central bank of the United States — the Federal Reserve System — and, consequently, the entire commercial banking system over which the Federal Reserve has oversight — has been run in a manner directly contrary to its own founding principles. These are clearly expressed in the Federal Reserve Act of 1913.

Briefly, the Federal Reserve System was founded on the assumption that the principles of the British Banking School are valid. That is, the real bills doctrine and Say's Law of Markets accurately describe economic and financial reality. At the heart of the British Banking School is the definition of money as anything that can be used in settlement of a debt. This means that not only coin, currency, and demand deposits of "depository institutions" are "money," but also the enormously greater amount of promissory notes and bills issued by or drawn on individuals and businesses. The amount of what we might call "private sector money" (that is, money that is not issued by the State or by a commercial bank tied in to the central bank) dwarfs M1, that which most economists, analysts, and policymakers consider the "real" money supply, and which is limited to coin, currency, and demand deposits.

Unfortunately, while the Federal Reserve System was designed to run in accordance with the principles of the British Banking School — the real bills doctrine and Say's Law of Markets — it is actually run as if the tenets of the British Currency School are valid — and as if State absolutism were the foundation of a sound and stable social order instead of the most immediate and direct cause of its dissolution. The unconscious contempt for ordinary people built into the principles of the Currency School — and thus into public policy, especially as it relates to capital ownership and finance — blinds the powers-that-be to any solution founded on essential human dignity and individual sovereignty just as surely as it did during the Great Depression.

Blindness to the importance of ordinary people (and thus to the importance of the average citizen sharing in ownership of the means of production as well as or instead of limiting the great mass of people to a wage system job as their sole source of income) also prevents correctly identifying the causes of both the Great Depression and the current economic downturn, to say nothing of inhibiting the development of a viable solution. This makes sense, for unless we know what the problem is, we are not going to be able to develop a solution that has any real hope of being effective.

Obviously it was not the New Deal or any other action by the federal government or the Federal Reserve that brought an end to the Great Depression, any more than we can expect any action by either institution today to do anything other than make a bad situation worse. Only the immense increases in spending for war material brought an end to the Great Depression. Massive government intervention has attempted ever since to keep the economy on an even keel. The not unexpected result has been the creation of the illusion that the federal government and the Federal Reserve between them can somehow control the economy without reference to sound monetary or economic practice and theory.

This rejection of economic and financial reality has, in turn, resulted in a condition of functional overload for the State and, increasingly, the central bank. The Federal Reserve is attempting to control the economy instead of concentrating on its extremely limited and specialized role of providing a stable currency and adequate liquidity for the private sector on an as-needed basis. Both the State and the central bank are trying to do far more than they were ever intended or designed to do, with chaos and dissolution of the social order being the only possible outcome.


No comments: